Thursday, August 27, 2015

Robert Shiller on the New York Times argues that the stock market is expensive by historical standards using the cyclically-adjusted price earnings ratio (CAPE) that he has made popular through his writings since the late 1990s.

There is no doubt that the CAPE ratio for the US stock market is high by historical standards. Using Shiller's estimates it stands around 26 today, clearly above the historical average of about 17. What a higher CAPE means is that you are paying more for the same earnings. Earnings' growth could, of course, be different in the future. They might be lower because potential GDP growth is slowing down but they might be higher as profits as a share of GDP increases. If we assume the same number just for simplicity, a higher CAPE means that investors should expect a lower return if they buy the stock market today compared to an average year in the past.

What does it mean for the future price of the stock market? Shiller concludes that maybe we will see the stock market returning to historical averages (which implies a massive fall in the current values) or maybe we see what we saw in the late 90s where the market continues going up and reaching a CAPE of over 40 before crashing. As Shiller puts it we "just don't know".

But what about a third option? The market remains at a level around 25, as it is today and this implies that returns will be lower than historical averages. Is this possible and consistent with investors' expectations? Yes, under two assumptions. One is that returns in all other assets are also lower than historical averages. This is certainly the case today where interest rates on bonds are at very low historical levels and it is difficult to foresee a large increase in the coming years. The other justification for high CAPE ratios is that the risk aversion of investors has gone down relative to previous decades. While talking about low risk perception this week might not sound right, the reality is that the years while the stock market had CAPE ratios of around 17 where also the years where academics wondered about why risk aversion was so high among investors (what we called the equity risk premium).

How much do we need those numbers to change to justify higher-than-normal CAPE ratios? A quick calculation using current bond interest rates would tell us that the stock market at a 25 CAPE ratio offers a risk premium over bonds that is similar to what the stock market offered when the CAPE ratio was 17 (around 6-7%). In that sense, the stock market is not expensive, it is prices in a way that is consistent with historical levels. If you want to make the stock market cheap you just need to argue that risk premium should be lower than that. If you want to make the stock market very expensive you need to argue that interest rates on bonds will soon go back to historical levels. In that scenario the US stock market should go down by about 30-40% relative to current levels.

Predicting which scenario will be realized is not easy, as Shiller argues. But I wished that he would have considered as well the third possible scenario where current CAPE levels are fine and investors should get used to lower-than-historical returns but returns that are consistent with what is going on in other asset classes. Maybe we put too much emphasis on the bouncing back and crashing scenarios when we talk about stock prices and we forget a much more boring but as plausible one that delivers a less volatile stock market.

Antonio Fatas

I am the Portuguese Council Chaired Professor of European Studies and Professor of Economics at INSEAD, a business school with campuses in Singapore and Fontainebleau (France), a Senior Policy Scholar at the Center for Business and Public Policy at the McDonough School of Business (Georgetown University, USA) and a Research Fellow at the Center for Economic Policy Research (London, UK).